August 15, 2012

A Layman's Incomplete and Probably Inaccurate Understanding of The GFC

Foreword:It has been four years or so since the world went through the throes of financial upheaval known as the Great Financial Crisis. It was a complex event that will not doubt be analysed in depth by experts for years, if not centuries to come, as an example of what could happen. Sometimes we forget that we are still part of a grand experiment, and that nothing like our civilisation has ever existed before. This means that some lessons must be learnt the hard way. The recent LIBOR scandal however would suggests that the financiers are slow learners...This is blog posts crystallises my thoughts and understanding of the event, gleaned from various places over the last few years. I make no claims on accuracy or veracity -- it is labelled rant after all.Lastly, the terms I use below are only loosely connected to their actual meaning in the finance world. For example I use capital just so I can not use the word "money" so much. They mean the same thing here. And money just means something you can pay your debtors with.

Lets begin with some axioms:

There is a ceiling to the amount of money a bank can loan out

Therefore banks want to... realise the value of their loans as quickly as possible

They are therefore willing to sell some loans at a discount, in order to free up money which they can loan to someone else, so they can make more money

Perception of low interest rate is absolute, no relative. Thus if banks can borrow money at 1%, they can double the interest on their loans, i.e. 2%, and the perception of low interest rate is maintained. Whereas if the inter-bank loan rate was say, 20%, they can hardly add another percent without significantly affecting the number of people taking out loans.

If the profit banks make, derived from the difference between the interest rate at which they borrow money, and the interest rate at which they loan money, is high enough, then it is profitable to take on high risk loans. The increased risk of default is balanced by the greater reward.

Now for the play:

Easy credit meant more people are eligible to take out loans, most of which were used to buy houses

As a result, housing prices went up, and size of loans increased as a result

Some branches are opportunistic, and under-rated the risk of loan applicants so they can give them loans.

Banks started packaging high risk loans, which they were giving out due to the high profit margin, with low risk loans, and selling the entire package as low risk.

For example, suppose risk is 0..1, where 0 means the loan will definitely be paid back, and 1 means instant default. If one packages nine risk=0.1 loans with a single risk=0.5 loan, then the overall package was being sold with risk=0.14.

This practice inflates enormously the value of high risk loans, at the relatively small expense of low risk loans.

These packages were then further manipulated. e.g. taken apart and with individual loans sold at the risk rating of the overall package. This serves to obscure the high risk nature of some of the loans in the package.

For example, company A sells company B the above loans as a single package with risk=0.14. Company B then splits the package into five smaller portions, each with risk=0.14, and sells it to company C. If company C is lucky, it will be getting a good deal: two risk=0.1 loans instead of two risk=0.14 loans. If company C is unlucky, it will end up holding a risk=0.1 and a risk=0.5 loan.

These manipulation happened many times, to the point no one can be sure any longer of the true value of any individual loan.

Something happened at this point, I am not entirely clear what, but the effect was that financiers realised that some of the loans they hold are not worth what they are paid, so...

They raised interests rates to compensate for the suddenly higher risk of the loans they are holding, and;

They tried to sell off those loans who providence cannot be verified.

These had the effect of:

Increasing the number of defaults, and thus repossessions. As loan holders sold off houses in an attempt to recoup their costs, over-supply of houses depressed the price of houses, bursting the real estate bubble.

This meant that loan holders could not recoup their costs, and is thus operating at a loss

Devaluing the worth of loans with questionable providence, even if they are in fact low risk, and thus good loans.

This meant that loan holders were "stuck" with their loans

Both of these combined meant that:

Loans were worth a fraction of what they were worth before

Loans could not be converted into liquid capital

This freezing of capital, and the devaluing of assets lead to panic in the financial world:

Creditors called in their debts, especially from those debtors who specialise in mortages

But as mentioned above, the debtor's can't pay: the loans they have purchased with the money they had borrowed could not be converted back into capital.

As a result, debtors, often large financial institutions, go bankrupt or require injection of capital, i.e. "bail out"

Over all effect:

The collapse of major financial institutions

Erosion of trust in the financial systems

Devaluation of real estate

Increased homelessness as homes are repossessed

Increased unemployment as institutions closed

Slow down in the flow of credit as creditors become more reluctant to give out loans -- once bitten; twice shy.

Extreme devaluation in the assets and worth of investors, from banks to companies

These effects were not just limited to the U.S. The inter-connected nature of modern financial markets meant that banks and institutions all over the world lost billions if not trillions of dollars in worth, and the reduction in available credit pushed up the interests rates.

More importantly, this was not limited to private companies. Many banks are owned nationally, and thus governments around the world suffer in much the same way as private enterprises: